Pay for Underperformance?

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It seems to be a law of commerce that no incentive-compensation scheme works as intended for very long. When first introduced, stock options were widely embraced as both good management and good business. Sure, the Financial Accounting Standards Board squawked. But investors believed they had the key to making executives behave like owners. And executives continue to maintain that stock options are a golden carrot to lure talent without actually forking out millions for it.

Then came the epic bull market, which virtually guaranteed gains for option holders, even if the company's stock performance was less than stellar.

No one is predicting the decline of stock options as incentive compensation, but analysts and shareholder activists are beginning to look at them more critically. Last fall's burst of option repricing, spurred by the softening stock market, raised eyebrows. Analysts at Credit Suisse First Boston have just issued a report on the hidden cost of options in the banking industry.

As annual mega-grants have become commonplace, even a modest share-price increase can be worth millions. Indeed, large-company CEOs cashed in an estimated average of $13.5 million in options in 1998--up 53 percent from 1997. Rather than drive managers to continuously improve corporate performance, it is argued that in many cases, stock options have enabled these executives to retire to their yachts while their companies lag behind their competitors.

"Executives are reaping the benefits of their option plans even if their company's stock performance is below its peers or the market," remarks Jim Knight, a partner with the Chicago office of SCA Consulting LLC. "What we're seeing is compensation that's driven by how investors see a particular industry or whether the Dow pushes above 10,000, rather than by true improvement in performance."

Higher Hurdles

In response to the rumblings, some companies have begun to experiment with option plans that have higher payout hurdles for executives. Some set the strike price of options at a premium to the share price at the time of the grant. Others vest sooner if the stock increases to a certain price.

Unlike the conventional market-priced options, which are "in the money" as soon as the stock creeps above the grant price, these plans require that the shares appreciate--in some instances, as much as 50 percent--before they have any value and can be exercised. But even these approaches are problematic, because the hurdle price ultimately may not represent a substantial gain relative to peers or to the market.

The only approach that fully captures the connection between pay and performance is to index the value of the options against an external benchmark, such as a peer group or a broader market index. Very few companies are willing to do this. Notable among this minority is Broomfield, Colorado-based Level 3 Communications Inc.

The 2,700 employees at the telecommunications start-up, an alternate-access phone carrier, hold options that are indexed to the S&P 500. Referred to as "outperform stock option grants," these awards are worthless if the company's stock performance does not exceed the broader market's, while the ultimate strike price varies based on how much the stock outperforms the index.

"We knew we were wading into untested waters with an index program," says Level 3 CFO Doug Bradbury, "but as we talked to investors, we felt that they wouldn't invest in us unless they thought we could do better than other investments out there."

The program, which took effect when the company went public in April 1998, uses a modified Black-Scholes option-pricing model to assign a value to Level 3's options based on how much the company's stock outperforms the S&P 500. The option-holders take on more risk, because they get nothing if the stock keeps pace with the market index. But they also can obtain a much higher reward as the stock exceeds the index by an increasing amount.

"It's much less of a sure thing," concedes Bradbury, especially at a time when the S&P 500 has been averaging gains of more than 20 percent annually. "But we have a strong belief in the prospects of the company, and in our ability to influence how well it does."

Yes, But

Indexing has some very influential fans, including Federal Reserve chairman Alan Greenspan and investor Warren Buffett, as well as corporate-governance and compensation gurus. "As far as I'm concerned, no option program has any credibility unless it's indexed," says Nell Minow, a principal at LENS Inc., a money-managing firm in Washington, D.C. "Otherwise, we're just grading everybody on a curve. These are big boys. They don't need that."

A number of CFOs at companies with traditional stock-option plans concur that indexing such plans links pay to performance in a more direct way. "The spirit and philosophy behind indexing--that executives must do more than just go along for the ride--makes a lot of sense," offers Coors Brewing Co. senior vice president and CFO Tim Wolf.

Like other finance chiefs, Wolf attaches a substantial "but" to the concept. If one company indexes and another doesn't, he says, the company that indexes could be at a very significant disadvantage.

Adds Dell Computer Corp. senior vice president and CFO Tom Meredith: "I'm not against the concept, but unless the companies we compete against go down this path, we would impair our ability to attract talent, and we could lose key people. The quest for talent is brutal, and to the extent that it would add hurdles to attracting talent, I don't know why you would consider it."

The Accounting Problem

Another obvious problem with indexed options is how to account for them. There is no accounting charge on options whose strike price is fixed. But with indexed options, which have a variable strike price, the difference between the grant price and the exercise price must be recognized as a compensation expense. Although the charge is noncash, it affects reported earnings.

"What keeps companies from indexing is the perception that investors will have a hard time seeing through the accounting charge," says SCA Consulting's Knight.

"People don't like the accounting," observes Timothy Lucas, FASB's director of research and technical activities. FASB's aborted effort in 1994 to apply an accounting charge to all options would have leveled the playing field for all options, he notes.

Indeed, Becton Dickinson and Co. once indexed stock options, but altered its plan in part because of the accounting ramifications. Beginning in 1990, the Franklin Lakes, New Jersey, medical-technology company's top five executives were granted options priced below the market value of the firm's shares if the stock had outperformed the S&P 500 in the previous year (and higher if the stock lagged the benchmark).

Although the strike price was fixed, the company had to show an accounting charge to earnings when it granted options at a discount to the fair-market value of the stock. That changed in 1995, when the company reworked its executive-pay plan. "We don't change the price of the options [depending on relative stock performance], but we give out more or fewer shares," says senior vice president, finance, and CFO Ken Weisshaar.

As for Level 3, on April 23, the company reported a net loss of $105 million in its first-quarter 1999 results. Of that deficit, $18 million was attributed to the compensation expense associated with its indexed-option program. But CFO Bradbury doesn't fear investor fallout. "We took the view that this plan is right for the company and its shareholders, so let's spend time talking about it if we have to," Bradbury explains. And since under FAS 123 the value of traditional stock options must be disclosed in the financial-statement footnotes anyway, he argues, "investors appreciate our more- straightforward approach."

David Barden, a telecom analyst at J.P. Morgan Securities Inc., concurs. "The impact on the income statement is not an issue, because the expenses are noncash and are dwarfed by the company's long-range plans to build a business," he says.

Although Barden suggests Level 3 should be compared with its peers rather than with the S&P 500, he nevertheless has observed that the company's unique option program has influenced management focus on creating value.

The Next Wave?

In the March­April 1999 issue of the Harvard Business Review, Alfred Rappaport, professor emeritus at Northwestern University's Kellogg School of Management and widely hailed as the "father of shareholder value," made his case for indexed options in light of his concern that standard options "reward both superior and subpar performance."

"I kept reading these articles about how executive pay is out of control, but they missed the main point," Rappaport told CFO. "It's not that people are making obscene amounts of money; it's that some of them are making money that's not deserved." While Rappaport believes there is genuine interest in the pay plan, he doesn't expect much action soon.

For one thing, no one will take the idea seriously as long as the market climbs steadily upward. "It will be easier to sell once the market cools," he says. "In a bull market, you want to be paid for absolute performance, but in a more stable or bear market, you want to be paid for relative performance."

Rappaport also believes that FASB should level the playing field for indexed options by changing the accounting rules for variable options. Companies that grant indexed options should have the same choice that companies with standard options have under FAS 123: they can expense the value if they wish, or fully disclose it in footnotes. (FASB's Lucas doesn't anticipate that the board will take such a step, nor that it will again try to level the playing field by requiring an income charge for all options.)

The third factor that would trigger a move to indexed options, says Rappaport, would be if "a few opinion-leading companies" adopt such a plan. There are no legal or technical reasons why indexing would work only for young, entrepreneurial companies. But it will take a handful of mainline companies, especially under current accounting rules, to make the first move on principle--because indexing is a more appropriate way to link pay to performance.

"There's nothing to preclude an established company from initiating an indexed plan," Rappaport urges. "And these can be designed in such a way that folks who are near or outperform the index will make more money than they make with standard options. But it requires a leap of faith."

(Chart omitted)

Tough Math

Calculating the value of Level 3 Communications Inc.'s indexed options, says CFO Doug Bradbury, boils down to applying a multiplier based on the magnitude of Level 3's outperformance over the S&P 500 to the dollar value of outperformance. The multiplier is calculated by multiplying the annualized percentage point outperformance by 8/11 (the multiplier is capped at 8 when the spread is 11 points or more). For purposes of this chart, we have assumed that the index grows 10 percent, to $110. This means that Level 3's options are worthless until its stock climbs to $111. And while Company X's conventional options have value even though the stock trails the index, Company Y's become less valuable when compared with Level 3's, as the telecom's stock performs more strongly.

(Chart omitted)

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